How the Pound Sterling Could End Up the Biggest Victim of Stock Market Volatility

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Institutional positioning is the biggest threat to Sterling in the short term if global stock market volatility continues but the UK’s notorious current account deficit could also come back to bite it.

The Pound will be the biggest victim of fallout in the FX world if recent volatility continues in global stock markets, according to strategists at J.P. Morgan, while the UK’s notoriously large current account deficit could increasingly hurt Sterling if the market sell off persists beyond the short term.

J.P. Morgan’s warning comes after a week of mounting fears over a sudden increase of global inflation and interest rates that sent the VIX index, which is a “fear gauge” that measures volatility on the S&P 500, surging by more than 150% in a single session. It’s largest single day rise on record.

Inflation fears and the subsequent volatility in financial markets was brought about by a strong January jobs report from the US, which showed news jobs and wages growing at rapid rates, leading some observers to float the idea that the Federal Reserve may be less patient about raising rates in 2018 than it has in prior years.

Strategists at the US bank have studied previous instances where the “fear gauge” VIX index suffered the shock delivered to it last week and, after crunching some numbers, have found that there could now be considerable implications for currency markets in the short term.

“In historical instances when VIX surged above 35, in all instances [institutional money manager] positions were cut both on the long and short side (vs USD), on average a third over two weeks, and cumulatively by a half in the month following the spike,” writes, Daniel Hui, a strategist at J.P. Morgan, in a recent note.

Last week the VIX “fear gage” rose above 50 level, substantially over and above the 35 threshold in J.P. Morgan’s analysis, which suggests that those currencies that have seen large bullish bets placed behind them in recent weeks, or even large bearish bets, could be prone to a reversal.

“Currently positioning shows the biggest longs in EUR and GBP...The biggest shorts are in USD, JPY, and CHF, on average,” says Hui.

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Turbulence Ahead

In Layman’s terms, money manager bets that the Pound and Euro will rise in value over the coming weeks have reached abnormally large levels in recent times, while speculation that the US Dollar, Yen and Swiss Franc will fall has also been abnormally high.

All of these bets could now be on the verge of unwinding, which means the Pound and Euro could come under pressure in the weeks ahead while the Dollar and Yen receive a boost.

For this to happen at a time when the Brexit negotiations are once again entering a crucial stage, which were already expected to pose downside risks to the Pound, suggests the road ahead could be a bumpy one for Sterling regardless of what way the Brexit negotiations unfold.

“While our equity analysts believe that the equity market correction is primarily a technical, rather than fundamentally driven phenomenon, the risk is that narrative which was most associated with at least the initial phase of equity market weakness [inflation] endures as a permanent component of the consensus macro backdrop,” Hui writes.

These inflation fears were exacerbated Friday when the US government set out details of its new budget, which promises big increases in Federal government spending in addition to this year’s tax cuts and infrastructure investment program.

America’s 10 year yield rose to 2.877% during early trading in London Monday, taking it to its highest level since December 2013 as a result of the Washington budget plan.

Above: Pound-to-Dollar shown at 2 hour intervals.

The Road Could Get Even Bumpier Still

A crucial test of whether inflation fears, and their associated volatility, continue as a theme for markets will come this Wednesday when US inflation figures for the month of January are released. Any upside surprises risk more turmoil.

“Beyond temporary and one-time deleveraging, a protracted period of heightened volatility in risk markets will impact currencies through a standard balance of payments channel as volatility will deter short-term, yield-seeking capital flows,” says Meera Chandan, another strategist at J.P. Morgan.

This will exert upward pressure on current account surplus currencies and downward pressure on current account deficit countries. Broadly speaking, the current account reflects the difference between the amount of money that enters a country in a quarter and the amount that leaves, creating either deficits or surpluses.

The Euro area has a very large multi-trillion current account surplus and so, over the medium term, the anticipated negative effect of a reduction in money managers’ bullish bets on the currency may soon peter out before inflows of capital eventually resume.

“The worst current account position in G10 by some margin is the UK’s (-4.5%) followed by US and the dollar bloc countries (Australian, Canada and NZ between 2-3%),” says Chandan, before warning;

“This balance of payments pressure on deficit currencies is likely to be exacerbated in the current environment by the continued rise in core market bond yields that threatens a more profound reversal of the yield-seeking investor flows that have characterized the era of negative rates and QE.”

The J.P. Morgan team are recommending to clients that they bet on a fall in the value of the Pound relative to the Swiss Franc over the coming months, as a result of their analysis, with an entry point around the 1.2971 level and a stop loss at 1.3230.

“Long-term funding for this deficit has dried up since the Brexit referendum. The UK is thus entirely reliant on short-term capital funding and GBP hence vulnerable from an increase in market volatility that obstructs short-term inflows,” Chandan warns.

Above: Pound-to-Euro shown at hourly intervals.

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Friday’s press conference will take place at the sidelines of a security conference that is expected to see PM May unveil further details, on Saturday, about the UK’s post-Brexit security relationship with Brussels.